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November 5, 2012

Hedge Fund Investors Aren’t Benefiting From Expanding Rules: Survey

Ernst & Young finds costs are growing with investments in people and processes

Few investors see the benefits of increasing regulatory requirements for hedge funds, according to a new study.

Only 10% of institutional investors surveyed felt that the new regulations would protect their interests, and 85% rejected the notion that these would prevent the next financial crisis, according to Ernst & Young’s sixth annual survey of the global hedge fund market.

The survey, which was compiled by Greenwich Associates for Ernst & Young, compared opinions from 100 hedge fund managers with more than $710 billion under management and 50 institutional investors with some $190 billion allocated to hedge funds on current topics related to the hedge fund sector.

The findings showed that although the two groups agreed on increasing investments in headcount, technology and risk management, stark contrasts existed on compensation structure, fees and expenses.

“Our survey findings suggest that hedge fund regulations are not beneficial to investors, who overwhelmingly question their purpose and proliferation,” Ratan Engineer, global leader of Ernst & Young's asset management practice, said in a statement.

“It may still be worthwhile for hedge fund managers to constructively engage with regulators to help them stay focused on the main goal—financial stability—rather than introducing more costly or unnecessary requirements that investors feel are of little value.”

The survey uncovered areas of agreement between managers and investors, as well as sharp differences.

Implications of Regulatory Compliance

The survey found that managers were already seeing regulations increasing their costs for upgrades of compliance functions (34%) and technology dedicated to reporting (17%).

For their part, investors expected the additional compliance costs, yet they feared these expenses would be passed on to the funds.

“The general increase in costs, including regulatory-related expenses, has created barriers to entry and has resulted in the consolidation of funds that do not have the capital to support the costly infrastructure required,” Arthur Tully, co-leader of Ernst & Young's global hedge funds practice, said in the statement. “This is a trend we will likely see continue in the near future.”

Compensation: Unreconciled Differences

The gap between managers and investors on how compensation should align with risk and performance has shown no sign of narrowing since 2010, the survey found.

Ninety-four percent of managers surveyed in 2010 felt risk and performance were effectively aligned with investor objectives, while 50% of investors felt that way. In 2012, 87% of managers felt this was true, while only 42% of investors agreed.

In addition, more than two-thirds of managers said their compensation structure had not changed in the past three years. Just 14% said less was paid in cash, and 10% said compensation was subject to longer deferral periods.

Investors, by contrast, said less than 40% of compensation should be paid in cash. Instead, they preferred to see a larger portion paid in equity and deferred cash, subject to clawbacks.

This dissonance has not caused material redemptions, the 2012 survey found, nor did investors cite it as a key consideration for choosing a fund.

Selection Criteria and Redemptions

Hedge fund managers surveyed believed that historic long- and short-term performances were two of the top criteria that investors used to select a manager.

Investors, on the other hand, identified the investment team (82%), risk management (70%) and investment philosophy (66%) as the three most important initial screening criteria.

These findings suggest that during initial selection, confidence that managers can generate strong future returns is more important to investors than actual past performance, according to Ernst & Young.

Eighty-six percent of managers cited performance as the primary reason for redemptions. The same number of investors also saw this as important, but 84% were equally inclined to take their assets elsewhere when there were changes in key personnel.

Nearly two in three hedge funds surveyed had either added headcount in the front office or expected to do so in the near future in order to support asset growth and expansion of new strategies.

In addition, some 45% of hedge funds were adding personnel in middle-office, back-office, risk management and legal/compliance functions to support expected growth, client demands for transparency and increased regulatory requirements. And more than half were making technology investments in risk management, compliance and investment management systems.

Investors generally agreed with these outlays. Two-thirds said their managers needed to invest in risk management technology, and nearly 60% said their managers need to spend on investment management systems. However, although investors demanded more transparency, they also expected hedge funds to cover the costs.

Some two-thirds of managers indicated they passed on the cost of D&O insurance, as well as regulatory registration and compliance for the fund. More than half of investors said this was unacceptable, and about half said it was unacceptable for regulation costs to be passed on to the fund.

Evolving Fund-of-Funds Business Model

The study found investor support for emerging and start-up funds increasing, but there was an accompanying squeeze on margins, most notably from funds of funds. These were demanding and getting concessions from fund managers, particularly on fees (95%), and often in return for larger mandates (83%) and lock-ups (56%).

“This flies in the face of conventional wisdom that the largest managers are gathering all the assets,” Engineer said in the statement. “More particularly, a significant majority of funds say that they are investing in a ‘fund of one.’”

He said it was hard to assess whether a causal relationship existed between this trend and a squeeze on margins, “but there appears to be conclusive evidence that in each case, funds of funds, as investors, are demanding, and getting, a variety of concessions from fund managers.”